All economies have major structural and policy problems, but some problems are more important and urgent than others at particular times. In Venezuela, the most important economic problem is in the exchange rate system. A fixed exchange rate system with periodic devaluations tends to be more crisis-prone than other exchange rate regimes, especially in a country like Venezuela where inflation has historically been higher than that of its trading partners.

This is particularly important right now because opposition leaders who have called for the overthrow of the government have pointed to 57 percent inflation and widespread shortages of consumer goods as justification for (often violent) street protests over the past two months. Although the protests have failed to attract the working and poorer people who are most hurt by the shortages, they are still a major complaint – as is inflation – for most Venezuelans.

As recently as two years ago, in the first quarter of 2012, the exchange rate system wasn’t causing any crisis. The economy was growing at a healthy pace and inflation was falling, coming in at an annual rate of just 10.1 percent in the first quarter. However, in the fall of 2012 inflation began to rise and so did the black market rate for the dollar, which went from 12 BsF per dollar in October of 2012 to a peak of 88 in late February 2014. To many people it seemed like Venezuela was suffering from an “inflation-depreciation” spiral. This is a situation where the domestic currency loses value against the dollar, causing inflation, which then causes the currency to fall further, and so on. In extreme cases such a spiral can end in hyperinflation, and government opponents (including much of the domestic and international media) promoted the idea that this is where the economy has been headed.

Of course hyperinflation was never a real threat – and still isn’t -- but the relation between the rising cost of the black market dollar and the inflation rate was a serious problem. Fortunately, the government on February 19th announced a new exchange rate system, SICAD II, to break the cycle of inflation-depreciation. On March 24, private banks and brokers began selling dollars at a market-determined rate to anyone who wanted them, thus undercutting the black market.

Will the new exchange rate system work? So far, it seems to have tamed the black market. There was a huge drop in the black market rate after the announcement of the new system – it fell from 87.91 BsF/dollar on February 19 to a low of 57.06 on March 21. It has bounced around since then and at this moment (April 3) is at 69.76. We can expect fluctuations in the black market due to speculation, as participants try to figure out how that new system is going to affect the price of the parallel dollar. But it does seem like the upward trend of the black market dollar over the past year-and-a-half has been arrested. Most importantly, the SICAD II rate has been stable, declining slowly from 51.86 on the first day of operations (March 24) to 49.19 on April 1.

It is still early to draw conclusions, but so far the SICAD II system is off to a good start and may succeed in drawing currency exchanges away from the black market, and putting a circuit-breaker into the inflation-depreciation cycle that we have seen over the last year or so. It is important to keep in mind that some of the rise in the black market rate over the last year was driven by speculation, including people buying dollars because they thought it was a one-way bet. With SICAD II the government has shown that the price of the dollar can go down as well as up, and can be stabilized, even within a market-based system.

There are analysts who maintain that SICAD II will worsen the inflation problem, but this is unlikely. As Bank of America Merrill Lynch (BOAML) pointed out in their latest (March 21) report on Venezuela, most prices are already determined by the black market rate; and the SICAD II rate is significantly lower than the black market rate. Although the black market is not that big, it doesn’t have to be huge to determine a lot of prices. As long as there is enough demand for a supplier who is importing with black market dollars to be able to cover costs, that will determine the price at the margin and anyone who has access to cheaper dollars will make higher profits.

The BOAML report also makes it clear that Venezuela is very far from anything resembling a balance of payments crisis. According to the report, if you add up the liquid and near-liquid assets of the central bank, PDVSA, and other government holdings it sums to more than $50 billion, which is quite a healthy amount of reserves relative to Venezuela’s imports. The report estimates that even the gold reserves held at home, which account for about 70 percent of Central Bank reserves, could be converted to cash within about two months. Furthermore, Venezuela’s foreign public debt (including PDVSA) as a percent of GDP was stable at 27.6 percent of GDP from 2012-2013, and its current account balance improved by about 1.9 percent of GDP (as of third quarter 2013). The SICAD II system will also reduce Venezuela’s fiscal deficit, by making giving the government more bolivares for dollars that it supplies to this market.

BOAML finds it amazing, given these numbers, that Venezuela is paying the highest interest rates among emerging markets on its dollar-denominated sovereign bonds – several percentage points higher than Ukraine. They therefore see these bonds as a good buy for investors, given the high return and the low probability of default. It’s tough to argue with their analysis.

Of course Venezuela still has a number of important economic problems to resolve, perhaps most importantly the problem of shortages, and bringing down inflation. But it has taken an important step in the right direction with regard to the exchange rate.